Labour should stop obsessing about fiscal headroom and focus on debt

The following column by Gerard Lyons appeared in The Times on Tuesday 9th December. It focuses on why the UK government should focus on medium term debt outlook.

 Britain is heading towards a debt trap: an inescapable cycle of rising debt. This will hit us by the end of the decade, but financial markets will anticipate it before then.

The UK already faces a risk premium, with a high rate of borrowing on government debt. This is explained by the stickiness of UK inflation and concern about the fiscal outlook. The latter is a worry, even after the budget.

One important step that needs to be taken is to shift the policy focus away from the short-term obsession with the fiscal headroom. This is the buffer to meet the self-imposed fiscal rules.

Instead, policy should be based on the medium-term outlook for government debt. Only then will the serious state of the public finances be clear to all.

Why now? It’s one lesson to take from a budget that exposed our back-to-front fiscal process. The Office for Budget Responsibility (OBR) determines whether the headroom is met and this in turn drives policy.

Also, earlier this year, the third external five-year review of the OBR took place. Carried out by Dutch fiscal experts, its recommendations included enhancing communication of the sustainability of the public finances.

It was critical of the focus on fiscal headroom noting that, “Those we interviewed were consistent in their belief that this approach is unhelpful, as it threatens to obscure broader assessments of UK fiscal sustainability.” I was one of the outside experts consulted.

The short-term focus of the fiscal headroom results in taxes being seen as the primary tool to restore the buffer. In contrast, the medium-term fiscal outlook would underscore the need to control public spending to put future finances on a sounder footing. It would align policy with where financial markets are diverting their attention.

Markets were relieved by the budget because the hole in public finances was not as bad as feared and the chancellor rebuilt her fiscal headroom.

However, a problem persists. The fiscal numbers are not credible. A large fall in borrowing is outlined for the end of the decade, around election time. There’s little chance of that because of rising public spending.

This is a perennial problem. Recently the Centre for Policy Studies pointed out that between 1990 and 2019 there were 54 medium-term spending plans where we can judge the outturn. In every case, public spending turned out higher than forecast.

Indeed, the 14 years of Conservative rule saw total managed expenditure, which is the best measure of public spending, almost double to £1.3 trillion in 2024. Public spending rose sharply even though the opportunity to borrow to invest at very low long-term rates was missed and despite austerity in non-ringfenced departments.

Under Labour, spending is planned to reach just over £1.6 trillion in 2031. It will turn out higher, based on the government’s approach to welfare spending.

Public spending is already 45 per cent of GDP and the tax take is set to reach an all-time high of 38.3 per cent of GDP by 2030-31. Traditionally the UK tax take has been stable, but lower. Now, in the legacy of the pandemic, both public spending and taxes are about five percentage points of GDP higher than pre-pandemic.

Regularly the OBR outlines the medium-term outlook in its fiscal risks and sustainability report. This attracts the attention of economists and financial markets. It’s fast becoming the most important piece of work produced on the fiscal outlook. It needs to drive the actions of politicians, even though it looks beyond the electoral cycle.

On current trends, the ratio of national debt to GDP is set to rise above 270 per cent of GDP over the next half-century, from just under 100 per cent now. It deteriorates continuously, through every parliamentary term.

One worry is that the UK, along with France among advanced economies, is more reliant on international investors to fund its debt. France ran into trouble in bond markets a few months ago when its politicians were unable to push through necessary pension reform. We should view that as a warning sign of problems that both France and we are likely to face.

There is a need to change the UK’s terms of reference. European countries with high tax rates are often cited as reasons to justify rising spending and taxes. But high tax, high public spending western Europe stands out globally as having the lowest growth rate. Our competitive landscape needs to be set by fast-growing regions, such as the US and Asia.

The markets know that if you fund higher spending through taxes, the economy will suffer, or through increased borrowing then yields will remain high.

If public spending keeps rising, the government could turn to the Bank of England to help through quantitative easing. But QE caused many problems and there is a need to guard against a return to it.

The longer we leave it, the more the UK would have to run a primary surplus in its government finances each year, just to stabilise its debt. A primary surplus means government revenues exceed spending after taking out interest payments. It’s a tall order.

Markets will not only demand a credible vision but also a quantifiable fiscal rule. The UK is on its tenth version of fiscal rules since their introduction in 1997.

A target for public spending over the course of the cycle is one approach. Politically, though, this may be difficult. Instead, a target to reduce the ratio of debt to GDP would be consistent with future fiscal solvency. A target could be set over a five and ten-year cycle.

Now is the time to focus policy on the medium-term debt outlook instead of fiscal headroom. That change would force proper control of public spending and stop politicians from kicking the can down the road.

This article is for information purposes only and does not constitute financial advice.